Once upon a time, there was an investor named Goldilocks. She went for a walk in the forest and soon came upon an investment advisor’s house. She knocked and when no one answered, she walked right in. Spread on the kitchen table there were three investment proposals. Goldilocks was hungry to invest. She started to examine the proposals…
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Too risky, too safe, or just right?
Just like Goldilocks found that the bears’ beds could be too hard, too soft, or just right, she would have an equivalent experience with the infinite ways to blend assets to create a portfolio. Some will be too risky – others too safe. She would hope to build the portfolio that is ‘just right’ to sleep as soundly as she did in the little bear’s bed.
The goal of any well designed portfolio is to maximize expected return relative to the level of risk that an investor is willing to take, and for Barclays, subject to the level of anxiety you are willing to suffer. Our choices around the allocation to bonds, equities, alternatives and cash have a large bearing upon this. At Barclays, we publish our ‘just right’ asset allocation guidance across five risk levels, suitable for investors from low through high risk tolerance. Cash is an important asset class. We stated in our white paper “Asset Allocation at Barclays”, published in February 2013, that:
This asset class plays a unique and essential role in Strategic Asset Allocations, especially for the most risk-averse investors. It is the only investment that fulfils the objective: ‘Make sure I retain my capital long term.’
Figure 1: Cash in the Barclays Strategic Asset Allocations
“That portfolio is too safe!” exclaimed Goldilocks
Many clients look at the cash allocation in our low risk strategic asset allocation and think it is very high. However, ask yourself this question: if you were one of the most risk averse investors in the population, then wouldn’t you want about half your wealth in the safest asset class?1
However, there is a temptation to build a low risk portfolio without using so much cash – perhaps placing a restriction that you hold no more than 10% in cash. It is possible to apply this constraint to the portfolio construction process and learn where the cash allocation gets redistributed. This can be seen in Figure 2.
Figure 2: An optimal low risk portfolio versus a low risk portfolio constrained to a 10% cash allocation
Figure 2 shows that the effect of constraining cash is to increase the allocations to Developed Government Bonds (from 8% to 36%) and to Alternative Trading Strategies (from 11% to 18%). All other allocations are constant or change by only 1percent.
How does the cash constraint alter the characteristics of these portfolios? Figure 3 gives the details. Developed Government Bonds yield more and are riskier than our Cash and Short-maturity Bonds asset class. Because the cash constraint raises the proportion of assets in Developed Government Bonds, then the expected return of the portfolio is higher – albeit only marginally – and the expected volatility is also higher.
The crux of this comparison is whether the increase in risk is adequately compensated for by additional return. The crucial idea is this – for every level of risk, an investor needs a minimum level of return in order to be willing to invest. This balance between risk and return is dependent upon the level of risk tolerance. Lower risk tolerance investors need higher levels of return than a high risk tolerance investor for the same risk. We call returns above this minimum threshold our measure of Desirability – higher is better.2
Our analysis of the two portfolios suggests that lowering the cash allocation reduces desirability, meaning the increased risk of the cash constrained portfolio is not fully compensated for by the additional return.
Figure 3: Portfolio comparison
The increase in risk can also be seen in a much simpler metric; the worst single month performance. For both portfolios, October 2008 suffered the worst performance. Our low risk strategic asset allocation lost 6.8% that month, whereas the cash constrained allocation lost 7.4%.
There is one other more tactical consideration. If interest rates revert to levels closer to their historical norms, then Developed Government Bonds are going to be affected much more than cash holdings. A cash constrained allocation might currently be running significantly higher concentration risk than history suggests. It is not that history suggests that the cash constraint is massively more risky, but concentration into a currently high priced asset increases the risk that history will not be a good guide. Our Goldilocks investor may think holding cash is too safe but she is perhaps shifting risk around in an extreme way.
Just like Goldilocks found that the bears’ beds could be too hard, too soft, or just right, she would have an equivalent experience with the infinite ways to blend assets to create a portfolio
“That portfolio is too risky!” exclaimed Goldilocks
Goldilocks may, like many investors, suffer from a problem of reluctance. Holding cash instead of a diversified portfolio provides emotional comfort but does so at a large opportunity cost – forgoing the expected return of that diversified portfolio. We discussed this in the February issue of Compass.4
Alternatively, Goldilocks may find herself maintaining the overall risk level of the portfolio by running a ‘barbell’ type strategy – one where a large cash holding is used to offset the risk of a higher risk investment portfolio. Some investors find this comforting, knowing that the low risk cash holding ‘secures’ their lifestyle and provides a buffer against the worst-case event. This strategy also has some downsides. Principally it reduces the diversification benefit by concentrating the investment portfolio in the riskiest asset classes. This can be particularly uncomfortable for low composure investors.
Figure 4 shows what happens to our high risk strategic asset allocation if you maintain the risk but choose to hold 30% in cash rather than the 2% ‘just right’ recommendation.
Figure 4: Optimal and cash boosted high risk portfolios
From Figure 4 it is clear to see that the riskiest emerging markets equity exposure has had to increase to keep risk and return high. Perhaps more important is the loss of the diversification benefit. Two of the bond asset classes do not feature in the cash boosted portfolio. The bond and alternatives asset classes collectively account for 30% of the strategic asset allocation but only 12% of the cash boosted allocation. This means that the performance of the portfolio is much more closely tied to equities with cash lowering the overall portfolio risk. More Figure 5 shows the effect this has on the portfolio metrics.
Figure 5: Portfolio comparison
By holding too much cash, investors may be giving themselves greater emotional buffers at significant costs to their portfolio efficiency. This may be a trade-off that makes sense if it helps to stay invested in all market conditions – but it may be one that leads to greater extreme outcomes in bad markets because diversification is reduced.
“Hmmm…that portfolio is just right!” exclaimed Goldilocks
My colleagues in the Behavioural Finance team would have a lot of sympathy for Goldilocks. We see lots of portfolios that are too safe and too risky, while constantly striving for the ‘just right’ portfolio. The ‘just-right’ portfolio is one that maximizes return relative to the stress and discomfort the investor has to endure along the journey. Our strategic asset allocations are the starting point for that, but we should also consider strategies to further boost the anxiety buffer where needed. Cash is just one of the ways of providing an anxiety buffer, but as Goldilocks learnt, it is by no means a costless way of achieving it.
1 From our calibration of risk tolerance on a global population we expect the 10% most risk-averse individuals to be classified as low risk investors.
2 More details on our desirability measure can be found in our white paper Asset allocation at Barclays, published Feb 2013.
3 Excess return is the return over and above the risk free return that can be achieved.
4 What is your wealth doing while you’re waiting for the right moment?, Compass, Feb 2013